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The Choices and the Trade Off

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The Choices and the Trade Off Aswath Damodaran 1 CORPORATE FINANCE LECTURE NOTE PACKET 2 CAPITAL STRUCTURE, DIVIDEND POLICY AND VALUATION B40.2302 Aswath Damodaran Aswath Damodaran 2 CAPITAL STRUCTURE: THE CHOICES AND THE TRADE OFF “Neither a borrower nor a lender be” Someone who obviously hated this part of corporate finance First principles 3 Maximize the value of the business (firm) The Investment Decision The Financing Decision The Dividend Decision Invest in assets that earn a Find the right kind of debt If you cannot find investments return greater than the for your firm and the right that make your minimum minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash rate fund your operations to owners of your business The hurdle rate The return How much The optimal The right kind How you choose should reflect the should relfect the cash you can mix of debt of debt to return cash to riskiness of the magnitude and return and equity matches the the owners will investment and the timing of the depends upon maximizes firm tenor of your depend whether the mix of debt cashflows as welll current & value assets they prefer and equity used as all side effects. potential dividends or to fund it. investment buybacks opportunities Aswath Damodaran 3 The Choices in Financing 4 ¨ There are only two ways in which a business can raise money. ¤ The first is debt. The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business. ¤ The other is equity. With equity, you do get whatever cash flows are le over aer you have made debt payments. Aswath Damodaran 4 Global Paerns in Financing… 5 Aswath Damodaran 5 And a much greater dependence on bank loans outside the US… 6 Aswath Damodaran 6 Assessing the exisng financing choices: Disney, Vale, Tata Motors, Baidu & Bookscape 7 Aswath Damodaran 7 Financing Choices across the life cycle Revenues $ Revenues/ Earnings Earnings Time External funding High, but High, relative Moderate, relative Declining, as a Low, as projects dry needs constrained by to firm value. to firm value. percent of firm up. infrastructure value Internal financing Negative or Negative or Low, relative to High, relative to More than funding needs low low funding needs funding needs External Owner’s Equity Venture Capital Common stock Debt Retire debt Financing Bank Debt Common Stock Warrants Repurchase stock Convertibles Growth stage Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Start-up Rapid Expansion High Growth Mature Growth Decline Financing 8 Transitions Accessing private equity Inital Public offering Seasoned equity issue Bond issues The Transional Phases.. 9 ¨ The transions that we see at firms – from fully owned private businesses to venture capital, from private to public and subsequent seasoned offerings are all movated primarily by the need for capital. ¨ In each transion, though, there are costs incurred by the exis]ng owners: ¤ When venture capitalists enter the firm, they will demand their fair share and more of the ownership of the firm to provide equity. ¤ When a firm decides to go public, it has to trade off the greater access to capital markets against the increased disclosure requirements (that emanate from being publicly lists), loss of control and the transacons costs of going public. ¤ When making seasoned offerings, firms have to consider issuance costs while managing their relaons with equity research analysts and rat Aswath Damodaran 9 Measuring a firm’s financing mix … 10 ¨ The simplest measure of how much debt and equity a firm is using currently is to look at the proporon of debt in the total financing. This rao is called the debt to capital rao: Debt to Capital Rao = Debt / (Debt + Equity) ¨ Debt includes all interest bearing liabilies, short term as well as long term. It should also include other commitments that meet the criteria for debt: contractually pre-set payments that have to be made, no maer what the firm’s financial standing. ¨ Equity can be defined either in accounng terms (as book value of equity) or in market value terms (based upon the current price). The resulng debt raos can be very different. Aswath Damodaran 10 The Financing Mix Queson 11 ¨ In deciding to raise financing for a business, is there an opmal mix of debt and equity? ¤ If yes, what is the trade off that lets us determine this opmal mix? n What are the benefits of using debt instead of equity? n What are the costs of using debt instead of equity? ¤ If not, why not? Aswath Damodaran 11 Costs and Benefits of Debt 12 ¨ Benefits of Debt ¤ Tax Benefits ¤ Adds discipline to management ¨ Costs of Debt ¤ Bankruptcy Costs ¤ Agency Costs ¤ Loss of Future Flexibility Aswath Damodaran 12 Tax Benefits of Debt 13 ¨ When you borrow money, you are allowed to deduct interest expenses from your income to arrive at taxable income. This reduces your taxes. When you use equity, you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income. ¨ The dollar tax benefit from the interest payment in any year is a funcon of your tax rate and the interest payment: ¤ Tax benefit each year = Tax Rate * Interest Payment ¨ Proposion 1: Other things being equal, the higher the marginal tax rate of a business, the more debt it will have in its capital structure. Aswath Damodaran 13 The Effects of Taxes 14 ¨ You are comparing the debt raos of real estate corporaons, which pay the corporate tax rate, and real estate investment trusts, which are not taxed, but are required to pay 95% of their earnings as dividends to their stockholders. Which of these two groups would you expect to have the higher debt raos? a. The real estate corporaons b. The real estate investment trusts c. Cannot tell, without more informaon Aswath Damodaran 14 Debt adds discipline to management 15 ¨ If you are managers of a firm with no debt, and you generate high income and cash flows each year, you tend to become complacent. The complacency can lead to inefficiency and invesng in poor projects. There is lile or no cost borne by the managers ¨ Forcing such a firm to borrow money can be an andote to the complacency. The managers now have to ensure that the investments they make will earn at least enough return to cover the interest expenses. The cost of not doing so is bankruptcy and the loss of such a job. Aswath Damodaran 15 Debt and Discipline 16 ¨ Assume that you buy into this argument that debt adds discipline to management. Which of the following types of companies will most benefit from debt adding this discipline? a. Conservavely financed (very lile debt), privately owned businesses b. Conservavely financed, publicly traded companies, with stocks held by millions of investors, none of whom hold a large percent of the stock. c. Conservavely financed, publicly traded companies, with an acvist and primarily instuonal holding. Aswath Damodaran 16 Bankruptcy Cost 17 ¨ The expected bankruptcy cost is a funcon of two variables-- ¤ the probability of bankruptcy, which will depend upon how uncertain you are about future cash flows ¤ the cost of going bankrupt n direct costs: Legal and other Deadweight Costs n indirect costs: Costs arising because people perceive you to be in financial trouble ¨ Proposion 2: Firms with more volale earnings and cash flows will have higher probabilies of bankruptcy at any given level of debt and for any given level of earnings. ¨ Proposion 3: Other things being equal, the greater the indirect bankruptcy cost, the less debt the firm can afford to use for any given level of debt. Aswath Damodaran 17 Debt & Bankruptcy Cost 18 ¨ Rank the following companies on the magnitude of bankruptcy costs from most to least, taking into account both explicit and implicit costs: a. A Grocery Store b. An Airplane Manufacturer c. High Technology company Aswath Damodaran 18 Agency Cost 19 ¨ An agency cost arises whenever you hire someone else to do something for you. It arises because your interests(as the principal) may deviate from those of the person you hired (as the agent). ¨ When you lend money to a business, you are allowing the stockholders to use that money in the course of running that business. Stockholders interests are different from your interests, because ¤ You (as lender) are interested in geng your money back ¤ Stockholders are interested in maximizing their wealth ¨ In some cases, the clash of interests can lead to stockholders ¤ Invesng in riskier projects than you would want them to ¤ Paying themselves large dividends when you would rather have them keep the cash in the business. ¨ Proposion 4: Other things being equal, the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use. Aswath Damodaran 19 Debt and Agency Costs 20 ¨ Assume that you are a bank. Which of the following businesses would you perceive the greatest agency costs? a. A Large Technology firm b. A Large Regulated Electric Ulity ¨ Why? Aswath Damodaran 20 Loss of future financing flexibility 21 ¨ When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt. ¨ Proposion 5: Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects. Aswath Damodaran 21 What managers consider important in deciding on how much debt to carry... 22 ¨ A survey of Chief Financial Officers of large U.S. companies provided the following ranking (from most important to least important) for the factors that they considered important in the financing decisions Factor Ranking (0-5) 1.
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